Stress test

It’s well known that a major cause of the credit crunch was the failure of
investment banks to properly price risk in their sub-prime mortgage-backed
assets dealings. But the world’s most powerful regulators are now saying that
another significant failing was that banks didn’t understand or even have a full
picture of their risks.

The Senior Supervisors Group comprises the Financial Services Authority and
bank regulators from Germany, France and Switzerland, as well as four US
regulators including the Securities and Exchange Commission and the Federal
Reserve. The SSG produced a report for the Bank for International Settlements in
March entitled Observations on Risk management practices during the recent
market turbulence. Couched in caveats, the two most important are (i) it is
based on analysis of just 11 of the largest banking and securities firms and
(ii) the credit crunch isn’t over yet.

Out of control
One conclusion is that some firms “made strategic decisions to retain large
exposures to … collateralised debt obligations that far exceeded the firms’
understanding of the risks inherent in such instruments”. Not surprisingly,
therefore, it says that such firms failed “to control or mitigate those risks”.

The SSG adds that firms failed to consider the risk that off-balance sheet
vehicles might need to be funded on the balance sheet right at the time when it
becomes difficult or expensive to raise funds externally.

But some firms avoided such problems. The SSG says they were the ones that
“demonstrated a comprehensive approach to viewing firm-wide exposures and risk,
sharing quantitative and qualitative information” and “engaging in more
effective dialogue across the management team”.

Gordon Burnes, vice president for sales and marketing at governance, risk and
compliance software group OpenPages, explains that many organisations, not just
in financial services, treat all their different risks as “silos” and fail to
take an enterprise-wide view of their risk exposures.

Separately, a BIS working paper says that current risk management systems
failed to provide adequate stress tests and that they measure risk over
comparatively short-term time horizons.

The net result is that current risk measurement systems are pro-cyclical,
“tracing risk as it materialises rather than… gauging the likelihood of its
future materialisation”. It adds that better risk management systems would be
inadequate unless there is also a change in remuneration systems to “combine
limited downside risk with high upside potential”.